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Monday, December 17, 2007

Who Wins on Stock Spreads?

In an earlier post, I explained that stock trading costs consist of the visible commissions and the less visible costs due to stock spreads. In the case of commissions, it is obvious who gets the money – the brokerage. In the case of stock spreads, it is less obvious where the money goes. If traders lose money due to spreads, who gets this money?

You could imagine a stock trading system where potential buyers and sellers each submit a price and a number of shares, and a computer tries to match them up. This sort of system might work well for a very liquid stock that trades millions of shares each day, but it wouldn’t work as well for thinly-traded stocks.

Suppose that you are looking to sell 100 shares of little known XYZ stock, and for three days running there haven’t been any reasonable bids to buy the stock. You would be quite unhappy. To make the system run more smoothly, each stock has one or more market makers whose job is to create a market in that stock. Market makers are always willing to buy or sell the stock at prices they specify. Each stock market imposes different rules on market makers to prevent abuses, such as maintaining an unfairly large spread between bid and ask prices.

To answer the question asked at the beginning of this post, the money lost by traders on spreads goes to market makers. But this doesn’t mean that market makers make money on every trade. Market makers constantly have to guess what prices to quote for their stock, although they have the advantage of seeing the bids made by traders.

In the example where you wanted to sell your 100 shares of XYZ stock when no traders were bidding, it is the market maker who would buy the stock from you. This means that market makers at various times own some stock or are short some stock.

If a market maker isn’t doing his job well, it is possible for a day trader to trade against him and make money. In this case, the day trader is acting like a market maker. (Warning: for every day trader who succeeds at this, a great many day traders lose all their money trying. Day traders have to pay commissions, and don’t have access to all the information the market maker has.)

A market maker’s income from trading will be variable, but over time, the market maker will earn the money stock traders lose from stock spreads.